San Francisco, CA (PRBuzz.com) November 19, 2012 -- Some option traders recently experienced the stress of seeing their holdings lose value because the markets unexpectedly closed. The surprise glitch, though trading stopped, the clock did not.
Time is of the utmost importance when pricing stock options, which wager on the direction a company's shares are likely to move.
Doug Estradt, founder of Pennwall Capital, manages approximately $10 million and stated that he expected to be punished as a result of the market closing for two days, which he finds extremely frustrating because their operations are so extremely electronic. In comparison to NYSE Eruonext's NYX -0.95% New York Stock Exchange operating on the trading floor, U.S. shares are mostly bought and sold via computer networks.
Regarding lost time, stocks differ from options. Option contracts come with a fixed expiration date and the amount of time until that date greatly affects the option's price. Loss of time, or "time decay", can significantly affect options with a shorter amount of time until expiration, like weekly options.
Steve Claussen, chief investment strategist at online broker OptionsHouse, says weekly options have become very popular. Before the unexpected markets closure, traders finished before the weekend thinking that they had five trading days to make or lose money. They ended up losing two-fifths of that time.
Without an offsetting rise in implied volatility, option investors' value of contracts are liable to decline sharply if markets reopen. Implied volatility reflects the expectation for big stock swings.
Todd Salamone, director of research at Schaeffer's Investment Research, stated that the unexpected markets closing was an unprecedented event and that there would be serious decay in some 'long' options.
The market shutdowns completely changed the plans for Mr. Estadt, who was planning to close out of weekly option positions early. He sold weekly "put" options that grant the right to sell shares at a set price. Mr. Estadt planned to profit by selling the puts if shares remained above the set prices. He was hoping to profit from the decaying time value by buying back the puts at a cheaper price early in the week, but that didn't happen.
Compounding the problem, market makers who take the other sides of investors' trades could face trouble trying to figure out option's cost when the market reopens.
According to OptionsHouse's Mr. Claussen, "People won't know where to set the prices. There are models for option pricing, but this is unprecedented. The liquidity providers will be very cautious in taking the prices too low immediately."
CBOE Holdings Inc. (CBOE -0.40%), the operator of the Chicago Board Options Exchange, announced greater flexibility in pricing once the market reopened. In a late notice Tuesday evening, the exchange said it would let initial prices fall within a wider range than usual as trading begins Wednesday.
Investors who bought option contracts will likely suffer from the two-day trading halt. On the other hand, traders who sold option contracts and collected money upfront will benefit. For these types of traders, fewer sessions before expiration can help ensure they hold onto those payments.
All U.S. options exchanges were closed Monday and Tuesday as well as the U.S. stock exchanges.
"We're a derivative of a stock. None of the options markets can open if the underlying stock exchanges are closed. There is nothing we can do about it," said Gail Osten, a spokeswoman for the Chicago Board Options Exchange.
Joe Kinahan, chief derivatives strategist at TD Ameritrad (AMTD -0.45%), expressed, "Everyone is upset when they lose money, but to the exchanges' credit, they did what was most prudent under the conditions. It's better that they said they were closed rather than risk having something go wrong in the middle of the trading day."
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